On 18 September, the African Development Bank announced a first for a multilateral development bank (MDB): a deal to transfer the risk embedded in US$1 billion in loans already made by the AfDB to a group of investors, for a fee. This deal may be the first step in a major shift in how MDBs manage their finances to expand lending capacity.
The development community is pushing MDBs to do more to achieve international goals—filling the yawning infrastructure gap, improving social services and addressing global problems such as climate change, migration and pandemic disease.
Unfortunately, the generosity of MDB member countries has not matched these ambitious goals. MDBs need a strong base of capital to be able to act on the scale required. The recent capital increase at the World Bank was a move in the right direction, but much more is needed, and shareholders are unlikely to be forthcoming.
As a result, MDBs have increasingly sought creative techniques to make better use of their existing financial capital. This is a good thing, and long overdue: for decades, MDBs have been content to use the same old model of making public sector loans that sit on their balance sheets for 20 or 30 years, locking up capital that might be better used elsewhere.
AfDB 'synthetic securitisation' creates lending headroom
The 'Room2Run' transaction (as AfDB has named it) is one example of these financial innovations. It is a 'synthetic securitisation' that frees up space for the AfDB to make US$650 million more in loans, without requiring further capital from shareholders. In essence, the deal functions like an insurance policy provided by investors on a chunk of AfDB loans.
This type of securitisation is becoming increasingly common in financial markets since the 2008 global financial crisis, but has never been attempted by an MDB.
A synthetic securitisation differs from the sorts of securitisations that helped cause the financial crisis in important ways. Most notably, the loans themselves stay on the books of the AfDB—hence the AfDB has every incentive to ensure they are good projects and to engage in strong oversight. By contrast, commercial banks prior to the global crisis could actually sell off loans (like mortgages) to an investor and get rid of them entirely—hence they had little incentive to ensure those loans were high quality.
Setting up Room2Run took the AfDB nearly four years of hard work—lining up the investors (led by Mariner Investment Group) and convincing rating agencies that the deal should give the AfDB enough lending headroom to make it worth the fee paid by AfDB.
Other MDBs and their member shareholders have followed the deal with great interest. The concept makes a lot of sense. If investors want to take on risk for a reasonable fee, and the transaction creates space for more lending, this could go part way to addressing the constraints on MDB lending, without needing more money from shareholders.
The AfDB deal did in the end require some official support, in this case from the European Commission, to get it over the line, but future deals may well be done on a fully market basis as investors and rating agencies get more comfortable with the concept.
Scaling up the concept to other MDBs
The trick is how to scale this up. Room2Run involved loans to private sector borrowers in African countries. Other private sector MDB loan portfolios could back similar transactions.
However, the bulk of MDB loans in developing countries are to governments, and these are all priced exactly the same and at a subsidised rate, regardless of the riskiness of the borrower. That makes sense for a cooperative bank like an MDB, but it makes it difficult to securitise. Someone has to cover the margin between the subsidised pricing of an MDB loan and the risk-based market pricing that investors use.
One way to address this is to ask donors for support, but depending on donor generosity is not a sustainable model. Another approach, currently under consideration at the G20, is to create platforms to permit the securitisation of pools of loans from several MDBs. This creates greater diversification and allows the balancing of risks, which would make deals more attractive to investors.
The rub is getting MDBs and their shareholders to agree. MDBs are often rather jealous of their turfs, and wary of anything that smacks of being part of some global 'system'. But creating voluntary platforms that MDBs can participate in, if they so choose, could be a viable solution.
A first step would include the World Bank and four major regional MDBs (Africa, Latin America, Asia and Europe), and in a later phase could be expanded to include other AAA-rated MDBs, including European Investment Bank, Islamic Development Bank, or the new China-led Asian Infrastructure Investment Bank.
The time has come to move past old-fashioned, conservative views on how MDBs should manage their finances. The world’s development needs are simply too massive, and MDBs are extremely well placed to encourage greater private sector investment and fill the gaps where private investment won’t go. The AfDB’s landmark transaction is a great first step, but needs to be followed up with more concerted action by other MDBs and their government shareholders.
